What Is the LIBOR Transition and What Comes Next?

The London Interbank Offered Rate, commonly known as LIBOR, served as a global interest rate benchmark for decades. It was a primary reference point for countless financial products worldwide, influencing everything from corporate loans to consumer mortgages. This benchmark has been phased out, marking a significant shift in the global financial landscape. The discontinuation of LIBOR necessitates a transition to new reference rates, impacting financial contracts and participants. This move aims to establish more robust and reliable benchmarks for the future.

Understanding LIBOR

LIBOR represented the average interest rate at which a select group of leading banks in London indicated they could borrow unsecured funds from other banks. It became an important benchmark for pricing various financial instruments across global markets.

The rate was calculated daily by the Intercontinental Exchange (ICE) and published by Refinitiv. Panel banks submitted estimates of what they would be charged if they were to borrow from other banks. For calculation, the highest and lowest estimates were removed, and the remaining submissions were averaged. This process yielded different LIBOR rates, spanning five currencies and seven different borrowing periods.

LIBOR’s influence extended broadly across the financial system. It was used to set interest rates for a wide range of products, including adjustable-rate mortgages, student loans, corporate loans, and various derivatives contracts. Hundreds of trillions of dollars in financial products were tied to LIBOR, underscoring its central role in global finance.

Reasons for the Transition

Despite its widespread use, significant flaws in LIBOR’s design and integrity led to the decision for its discontinuation. A significant issue was the declining volume of actual interbank lending transactions that underpinned the rate. Over time, banks increasingly funded their activities through diverse means, making the notion that LIBOR reflected genuine interbank deposit rates largely theoretical.

The reliance on subjective estimates, rather than observable transactions, made LIBOR susceptible to manipulation. This vulnerability was clearly exposed during the LIBOR manipulation scandals. Several major global banks were implicated in colluding to falsely increase or decrease their rate submissions to benefit their trading positions. These actions eroded confidence in the rate’s integrity and validity.

The scandals prompted a regulatory push for LIBOR’s cessation. Regulators globally determined that a benchmark based on estimated rates and lacking sufficient underlying transactions was no longer viable. The regulatory consensus emphasized the need for new reference rates that are more robust, transparent, and based on actual, observable transactions. This shift aims to create a more resilient financial system less prone to manipulation and more reflective of genuine market activity.

Alternative Reference Rates

The discontinuation of LIBOR has led to the development and adoption of Alternative Reference Rates (ARRs), often referred to as Risk-Free Rates (RFRs). These new benchmarks are designed to be more robust and reliable than LIBOR because they are based on actual, observable transactions in liquid markets. This transactional basis helps to mitigate the risks of manipulation and provides greater transparency. ARRs are “near risk-free” as they reflect overnight borrowing costs and do not inherently include a bank credit risk component, unlike LIBOR.

For the U.S. Dollar, the primary alternative is the Secured Overnight Financing Rate (SOFR). SOFR measures the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. It is a broad measure based entirely on observed transactions in this active market, making it highly representative and less susceptible to manipulation. SOFR is published daily by the Federal Reserve Bank of New York.

Other major currencies also have their recommended ARRs. For the British Pound, the Sterling Overnight Index Average (SONIA) is the preferred alternative. SONIA is based on actual overnight unsecured lending transactions in the wholesale market. The Euro Short-Term Rate (€STR) serves as the alternative for the Euro, reflecting the overnight unsecured borrowing costs of banks in the euro area. For the Japanese Yen, the Tokyo Overnight Average Rate (TONA) is the recommended risk-free rate, also based on overnight unsecured transactions.

A key difference between ARRs and LIBOR lies in their nature. LIBOR was a forward-looking rate, published for various terms (e.g., one month, three months), and included an element of bank credit risk. In contrast, ARRs are backward-looking, reflecting overnight rates, and do not incorporate a credit risk component. This distinction means that financial products transitioning from LIBOR to ARRs may require adjustments, such as a credit spread adjustment, to account for the absence of the credit risk element present in LIBOR.

The Transition Process

The transition away from LIBOR has been a multi-year process with specific deadlines for various currency settings. Most LIBOR settings ceased or became unrepresentative at the end of 2021. However, certain U.S. dollar LIBOR tenors continued to be published until June 30, 2023, to allow for an orderly transition of legacy contracts. This staggered approach provided market participants with time to adapt.

A major focus of the transition has been addressing existing “legacy” contracts that reference LIBOR. These include a vast array of financial instruments, such as corporate bonds, syndicated loans, derivatives, and consumer products like adjustable-rate mortgages. For contracts that mature after LIBOR’s cessation, market participants have worked to amend them to reference alternative rates. This often involves incorporating “fallback language” into agreements, which specifies an alternative rate that automatically applies if LIBOR is no longer available.

The International Swaps and Derivatives Association (ISDA) played an important role by developing the ISDA Fallbacks Protocol. This protocol allowed market participants to unilaterally amend existing derivatives contracts to include robust fallback provisions, providing a standardized and efficient way to transition these agreements. For other financial products, such as loans, parties negotiate bilateral amendments to their contracts to replace LIBOR with an ARR, often SOFR for U.S. dollar-denominated agreements, plus an agreed-upon spread.

The U.S. Congress further supported this process by enacting the Adjustable Interest Rate (LIBOR) Act. This legislation provides a statutory framework for contracts that lack fallback provisions, ensuring a smooth transition to a benchmark based on SOFR. The Federal Reserve Board subsequently adopted a final rule implementing the LIBOR Act and specifying the replacement rates for such contracts. This legislative and regulatory support helped to minimize potential disruptions and legal uncertainties.